Financial conditions impact money elasticity in production networks
A new Bank for International Settlements working paper explores how financial conditions influence money elasticity and firm activity within production networks. The study finds that tighter financial conditions significantly reduce output, with spillovers through production networks amplifying these effects.
Credit lines power production networks
The elastic supply of money, primarily through overdrafts and credit lines, is crucial for overcoming cash-in-advance constraints in payment systems.
This elasticity enables large-value payments without waiting for incoming cash, a mechanism particularly vital for firms operating in long production chains.
These firms often require substantial liquidity due to prolonged lags between production costs and sales revenue.
The paper highlights that undrawn credit lines serve as the operative link between money elasticity and working capital.
Empirical data shows significant demand for this liquidity: unused loan commitments range from 20% to over 100% of utilised credit across selected countries.
During the early stages of the Covid-19 pandemic, firms drew down an average of 20% of their outstanding debt via credit lines.
Tighter financial conditions, such as rising credit spreads or a stronger US dollar, significantly reduce output, with spillovers through production networks amplifying these effects.
Demand-driven dynamics of money
The paper addresses a gap in traditional money supply theories, which often inadequately capture the demand-driven nature of money elasticity.
While the 'loans create deposits' theory is more accurate than the loanable funds view, it still falls short of fully depicting how borrowers actively expand the money supply by drawing on credit lines.
The authors establish causality between money elasticity and firm activity by exploiting structural variations in firms' working capital demands, inherently influenced by their position within production networks.
They construct a cross-country panel dataset of firms (2005-2024) with undrawn credit lines, merged with World Input-Output Tables to derive measures of upstreamness and downstreamness.
The analysis reveals a robust positive correlation between firms' undrawn credit lines and their position within these networks, aligning with the conceptual framework.
The hidden cost of tight money
This study provides crucial empirical evidence for the real-world impact of financial conditions on firm activity, particularly through the often-overlooked channel of money elasticity and working capital.
The finding that network spillovers amplify output declines by two-thirds underscores the systemic importance of these dynamics for economic stability.
Policymakers must therefore consider the broader implications of financial tightening on supply chain resilience, beyond direct lending channels.